[This week's notes are on fiscal policy and correspond to Chapter
12 of McConnell's textbook. They were last revised on Thurs., Dec.
2, at 4:30 pm.]

LECTURE 30Mon., Nov. 15, 1999

* Today: Fiscal policy (begin)

I. FISCAL POLICY: AN INTRODUCTION

Here are a few examples of real-life economic policy decisions:
* In the early 1980s, the economy was slumping, and Congress in 1981,
in response, voted to cut tax rates by 25%. Many Congressman said they
voted for the tax cut because "we had to do something" to get the economy
moving again.
* In the late 1960s, during the Vietnam War boom, Congress imposed
a 10% tax increase ("tax surcharge") on corporate and personal incomes.
The purpose was to rein in private spending (AD) and the associated demand-pull
inflation, which by then had started to accelerate.
* In the 1990s, Japan's economy has been in a decade-long slump, and
the Japanese government has responded by repeatedly increasing its spending
and cutting taxes to boost aggregate demand.

--> Common thread: The government often uses its spending and taxing
decisions in order to influence the state of the economy.

Def. FISCAL POLICY-- the spending and taxing policies used
by the government to influence the economy.-- Fiscal policy can be complex (since there are many different taxes
and many different spending programs, and they have different multipliers
associated with them), but for now we will focus on changes in the absolute
levels of government purchases (G) and tax revenues (T).

G = purchases of goods & services by the government (federal,
state, & local). Note: does not include transfer payments (Social Security,
welfare), interest payments on the national debt (to government bond holders),
or subsidies.

Of the government's two main tools for managing the economy, fiscal
policy and monetary policy, Keynes and early Keynesians (economists who
generally agreed with Keynes's ideas) emphasized fiscal policy.

Fiscal policy can be either EXPANSIONARY or CONTRACTIONARY.

(1) EXPANSIONARY FISCAL POLICY occurs when the government deliberately
increases its deficit in order to stimulate the economy.-- In expansionary fiscal policy, the government increases
its spending (G) or cuts taxes (T) or both.-- Expansionary fiscal policy stimulates the economy because it increases
aggregate demand (AD).-- When the government increases G, it adds directly to AD, since
G is part of AD (= C+Ip+G+Xnet).
-- When the government cuts T, it increases people's disposable
income (total income minus taxes), and people will spend much of that
extra income, so
consumption (C) increases.
-- In both cases, AD will also increase indirectly through the multiplier
effect, as the initial increase in G or C touches off a whole chain
of consumption.
-- In both cases, real GDP will increase and so will the price level.
Expansionary fiscal policy (or a fiscal expansion) means the economy
is moving northwest along the Phillips Curve, to a point of lower unemployment
and higher inflation. (This is an example of
demand-pull inflation.)
Or, in terms of the AD-AS model, the AD curve shifts out, causing equilibrium
real GDP (Q) to increase and the equilibrium price level (P) to increase.
-- [See Figure 11-8(c) on page 235 of McConnell's book for the relevant
AD-AS diagram. This would be a good thing to know for the exam.]

(2) CONTRACTIONARY FISCAL POLICY occurs when the government deliberately
reduces its deficit in order to slow down the economy (usually with
the goal of reducing inflation).
-- In contractionary fiscal policy, the government cuts its
spending (G) or raises taxes (T) or both.-- Contractionary fiscal policy contracts the economy because it decreases
AD.-- The net effect of contractionary fiscal policy, all other things
equal, is to induce a recession or at least slow down the rate of growth
of the economy. A fiscal contraction would cause the economy to move southeast
along the Phillips Curve, to a point of
higher unemployment and lower
inflation. Applying the AD-AS model, a fiscal contraction causes
the AD curve to shift inward; as a result, equilibrium Q decreases and
equilibrium P decreases.-- [The relevant AD-AS diagram would be the opposite of Figure 11-8(c),
with the AD curve shifting in instead of out.]

II. FISCAL POLICY AND THE MULTIPLIER

When the government increases G, the people whom it pays for
those extra goods and services now have higher incomes, and they will spend
some of that extra income (consumption increases), touching off a whole
chain of consumption (C). The ultimate, cumulative increase in AD will
be a multiple of the original increase in G.

When the government cuts taxes, people spend their extra after-tax
income, and that initial increase in consumption leads to more consumption,
by the people who sell the goods or services in each round of consumption.
Again, because of the multiplier effect, the ultimate increase in AD
(which is entirely an increase in C in this case) will be a multiple of
the original tax cut.

When we draw the AD shifts that result from a fiscal policy change
on AD-AS diagrams, we draw just one big shift which corresponds to
both the initial change in AD (e.g., the increase in G or the initial increase
in C from the tax cut) and the subsequent change in AD (which arises from
the multiplier effect). We can think of there being one AD shift for every
step of the multiplier process, but that would be an awful lot of AD shifts
to draw.

-- Ex.: If the multiplier is 4 and G is cut by $5 billion, then the
initial AD shift would be a horizontal leftward shift of $5 billion and
the cumulative AD shift (which is the one we draw) is a horizontal leftward
shift of $20 billion (4 * $5 billion).
---- [See Figure 12-2 on page 246 of McConnell's book for an illustration
of this example.]

Combining this notion of fiscal policy changes as AD shifts with the
fact that the economy is normally on the upward-sloping part of the
AS curve, then we should note that a given increase in AD will cause
a somewhat smaller increase in equilibrium real GDP than the simple multiplier
model would indicate. What happens is that, as with any other increase
in AD, some of the supply response comes in the form of a higher quantity
supplied and some comes in the form of higher prices. If the economy were
on the flat (horizontal) part of the AS curve, the increase in AD and the
increase in Q would be the same.

Putting aside that important fact, however, and assuming for simplicity's
sake that the economy is on the flat part of the AS curve, the government
spending multiplier is the same as the regular multiplier:

{spending multiplier} = 1 / (1-MPC),

because G is a component of autonomous spending.-- If MPC = 0.8, then the government spending multiplier is 5 (= 1/(1-0.8)).

The multiplier associated with a given change in taxes, the tax
multiplier, is negative, because higher taxes reduce people's disposable
income, thereby reducing their consumption.The tax multiplier is
smaller (in absolute value) than the spending multiplier because not
all of a tax increase represents income that otherwise would have been
consumed -- the marginal propensity to consume is less than 1, so some
fraction of every dollar gets saved, which does not add to aggregate demand
or GDP.The initial change in consumption associated with a $1 tax
increase is

- MPC * ($1) = -MPC.

That amount is the change in autonomous spending that results from a $1
tax increase, and we multiply it by the regular multiplier to get:

Where we left off: What if the government increased spending (G) and
taxes (T) by equal amounts (say, $100 billion more of each)? For most of
us, our automatic response is to think that would somehow be a
bad
thing for the level of GDP, since higher taxes plainly lower our disposable
incomes and leave less for our consumption. Or we might think that it would
have zero effect on GDP, because the higher spending and the higher taxes
would seem to offset each other. But, in the context of the multiplier
model, both of those guesses would be wrong. Instead, an equal
increase in G and T would actually
raise GDP, in the context of
the multiplier model.-- Why: returning to what we did last time with the spending and tax
multipliers, recall that the government-spending multiplier is

{spending multiplier} = 1 / (1-MPC),

and the tax multiplier is

{tax multiplier} = - MPC / (1-MPC).

-- Add the two together and you get the multiplier for an equal increase
in government spending and taxes. Equivalently, it is the increase in equilibrium
GDP that results from a $1 increase in G and a $1 increase in T. We call
it the BALANCED-BUDGET MULTIPLIER(BBM; or perhaps more accurately
the tax-and-spend multiplier), and it is equal to the sum
of those other two:
{BBM} = 1/(1-MPC) - MPC/(1-MPC)
= (1-MPC) / (1-MPC)
(combining the two terms, which have a common denominator)
= 1

So the balanced-budget multiplier is 1, meaning that a given increase
in G (say, $1 million) coupled with an equal increase in T ($1 million)
would raise equilibrium GDP by that same amount ($1 million).
-- We call it the balanced-budget multiplier because an equal
increase in G and T would not change, let alone increase, the government's
budget deficit. If the budget were balanced to begin with (a deficit of
$0), it would still be balanced after an equal increase in G and T.
---- (The term balanced-budget multiplier does not necessarily
mean that the overall budget is in balance, just that we're increasing
G and T by equal amounts.)

-- This is a startling result. Having grown up in a conservative era
in which politicians of both parties say they're against "big government"
and talk about how they want to cut government spending, it's easy to forget
that government spending, even when it's wasteful, is counted in GDP provides
incomes for the people from whom the government is purchasing goods and
services. This, by the way, is why many political conservatives hate Keynes,
since Keynes originated the concept of the multiplier, including the balanced-budget
multiplier.

-- Why the balanced-budget multiplier is positive: The spending multiplier
is larger than the tax multiplier, because some fraction of any dollar
of income that is taxed would have been saved instead of consumed, and
savings do not contribute to GDP. (That fraction, by the way, is the
marginal propensity to save, and is estimated as .05 for the United States
today.)

Technical note: In these multiplier examples we've seen so far, the
type of tax we've considered is a
LUMP-SUM TAX, which is a tax
that is a fixed dollar amount that does not depend on income or consumption
or anything else in the multiplier model. If the U.S. government were
to impose a lump-sum tax of $100 on everyone, then every person, rich or
poor, would pay the same amount, $100. This obviously isn't the way most
taxes work, but it makes the math in these models way, way easier.
-- So if in an example we assume that T equals, say, $500, that means
there is a lump-sum tax of $500 (to be precise, $500 total, since
all of the variables in the multiplier model -- C, I, G, X, M, Q, S --
are totals for the whole economy.)

A three-part example

Let us compare the different equilibrium levels of GDP for the same
economy (1) with no government spending or taxes, (2) with government spending
but no taxes, and (3) with equal amounts of government spending and taxes.
Consumption, planned investment, and net exports in this economy are:

(2) Now assume that the government spends $100 but collects no taxes.
With a multiplier of 20, we can already conclude that equilibrium GDP will
be $2000 [=20*$100] higher than before and hence will be $22,000, but let's
do it the long way. The economy is now:

Comparing the results of (1) and (3), we see that equilibrium GDP is
$100 higher ($20,100) when the government taxes and spends $100 than when
government spending and taxes were both zero (equilibrium GDP was $20,000).
-- Another notable result is that despite the higher taxes in (3) as
compared to (1), private consumption is the same in both cases. To verify,
equilibrium consumption is:
---- in case (1): Cequil. = 500 + 0.95*Qequil. =
500 + 0.95*20000 = 500 + 19000 = 19,500
---- in case (2): Cequil. = 405 + 0.95*Qequil.
= 405 + 0.95*20100 = 405 + 19095 = 19,500
---- While the tax increase on its own would have hurt consumption
and GDP, the equal spending increase, through its larger multiplier effect,
raises GDP and leaves consumption unchanged. Society is better off in the
sense that consumption has not fallen and now there are $100 in extra government
services.

II. THE DEFICIT'S INFLUENCE ON THE ECONOMY

In simple multiplier models, like the ones we just did, the deficit
helps the economy and doesn't hurt it at all. In such models, the bigger
the deficit the better, because it will increase equilibrium GDP.-- There is no "limit" to GDP (no concept of "potential GDP" or "capacity
GDP") in the multiplier model.
-->

Q: So, then, why not have as big a deficit as possible? Eliminate
all taxes. Let every Congressperson's request for greater spending for
his or her district be granted, so that the government spends as much money
as it could ever imagine.
A:-- First off, the multiplier model applies to a depressed economy,
operating on the flat part of the AS curve; if we're only looking at a
range of low values of GDP, then we're so far away from potential GDP that
we don't need to worry about pushing the economy beyond its sustainable
limit. But bigger and bigger deficits would eventually increase GDP
to the point where it reached the intermediate part of the AS curve, at
which point larger deficits become inflationary.---- Once real GDP (Q) reaches potential GDP (Q*), larger deficits
cause not just increased inflation but also accelerating inflation.-- There are additional reasons, to be given in the next lecture, why
government deficits are not entirely a blessing.

In simple multiplier models, the government-spending multiplier,
as 1/(1-MPC), is huge, and the tax and balanced-budget multipliers are
also very large. Plugging in the estimated MPC for the U.S. today,
which is .95, the multiplier would be 20 (=1/(1-.95)=1/.05). The tax multiplier
would be -19 (= -.95/(1-.95) = -.95/.05 = -95/5), and the balanced-budget
multiplier would be 1.
-- In the real world, however, those multipliers are a lot smaller.
The spending multiplier is about 1.4, the tax multiplier is about -1.3,
and the balanced-budget multiplier is about 0.1, even though the U.S.
MPC, as noted, is about .95.
-->
Why the real-world multipliers are so much smaller than the ones
in the model: in real life,
there are several LEAKAGES from that whole chain of consumption
that drives the multiplier process, namely:(1) taxes on incomes and sales, which mean that some fraction
of every dollar spent goes not to the person selling the good or service
but to the government.
(2) imports - some of every extra dollar of consumer spending
is spent on imported goods instead of U.S.-produced goods, and imports
are subtracted from GDP. Also, the money spent on imports is mostly
re-spent in the foreign country that produced the import, not in the U.S.
(3) inflation - instead of passively responding to the increased
product demand by simply supplying more goods at the same price as before,
many producers will respond (and maximize their profits) by raising their
prices.Those higher prices mean inflation, and the increase in
real GDP will therefore be smaller than the increase in nominal GDP.
(4) higher interest rates as a result of the extra aggregate
demand. Some of that extra consumption spending is on expensive durable
goods, like cars and dishwashers, that are normally financed through consumer
loans. Increased demand for durable goods means increased demand for loans,
and the equilibrium interest rate will increase, thereby
crowding
out some of that durable-goods consumption and also crowding
out some investment.---- [I forgot to mention this 4th factor in Wednesday's lecture,
but it is important.]

We should also note that when these multipliers are so small (1.4 for
spending, -1.3 for taxes, 0.1 for BBM), the impact of any change in G or
T on equilibrium GDP is easily offset by a change in monetary policy, such
as a raising or lower of interest rates, by the Federal Reserve. Monetary
policy is what we'll be covering after this week.

***

WEEK 12, LECTURE 32Fri., Nov. 19, 1999

O. IMPEDIMENTA

* Today: Fiscal policy (lecture 3 of 4)

* Remember: This class will not meet next Mon., Nov. 22.-- [I handed out makeup lecture notes for that day when we got back
on Mon., Nov. 29. Those notes included: Measuring the national debt; The
economy's influence on the deficit; Fiscal history, 1789-1980; Supply-side
economics. Those makeup notes will not be posted on the web; if
you didn't get a copy, I do have a few extras.]

* QUIZ

I. DEFICITS AND DEBT: DEFINITIONS, PROBLEMS

Q: What does it mean to say, "The government is running a deficit?"
A: spending more than it takes in.
-- Is the U.S. government a deadbeat? Is it unable to pay its bills?
(No-- it can easily borrow enough to cover its deficit.)

Defn. Budget deficit: the difference between what a government spends
and what it collects in revenues in a given period-- roughly, G - T
-- more precisely, all expenditures, incl. transfers & int. on
debt minus all revenues, incl. tariffs & user fees).
-- currently is negative, because the government is running
a surplus; deficit = - $123 billion, ~ -1.4% of GDP

How does the government pay for its deficit? Options:

1. money financing: could print money (or have the Federal
Reserve buy bonds directly from Treasury and pay for them by creating money)
-- This is called "monetizing" the debt, or the "inflation tax," because
it tends to be extremely inflationary and has been the source of most hyperinflations.
-- It is most common in 3rd World countries.

2. debt financing: sell bonds -- what U.S. does, mainly (bonds=debt)
-- When bonds mature, government must pay interest plus principal (original
amount borrowed)
--> When that happens, the government's typically raises
the money to make those payments by selling more bonds.
---------- This is somewhat again to a classic scam known as a "Ponzi
game" or "Ponzi scheme." The difference is that the government is
doing all of this openly, and as long as people have confidence in the
government's ability to repay its debts, the government can keep on rolling
over its debt in this manner.)
-->

Defn. National debt (federal debt): ~ The total of all accumulated
federal deficits minus surpluses over time, or the total amt of U.S. government
bonds outstanding.-- currently ~ $3.6 trillion, ~39% of GDP (1999)
-- other countries' national debt: Japan, Germany-- slightly smaller
as % of GDP; Great Britain-- slightly larger; Italy-- over 100% of GDP!

History: the U.S. has had a national debt since George Washington's
time. (Alexander Hamilton, the first Secretary of the Treasury, thought
it would strengthen and unify the country by giving wealthy bondholders
a stake in seeing the government survive.) We touched "fiscal bedrock"
in 1835, when A. Jackson was president, thanks to revenues from tariffs
and public land sales.

Problems with deficits in the real world:

(1) In real world, a deficit typically leads to higher interest
rates; partial crowding-out of investment-- CROWDING OUT OF INVESTMENT refers to the tendency for
larger government budget deficits to cause investment (and durable-goods
consumption, which is also interest-sensitive) to decrease somewhat.
If the crowding out is complete, then investment and durable-goods consumption
fall by exactly the same amount by which the deficit increases, and the
deficit fails to increase real GDP at all. In the real world, crowding
out exists but is less than one-for-one -- an increase in the deficit of,
say, $50 billion, might cause investment and durable-goods consumption
to fall by $10-20 billion, but not by the full $50 billion.
---- How crowding out works: The government must finance
its larger deficits by selling Treasury bonds --> To get people to buy more
of those bonds, it has to offer a higher interest rate than it did before. --> The higher interest rate
on Treasury bonds cause interest rates to go up on other bonds and on bank
loans
(because more people buying Treasury bonds drains the supply of savings
that could be loaned out to corporations
and households), and because the cost of borrowing is higher,
--> fewer firms will borrow
money for new capital investment.-- In the simple multiplier model, by contrast, Ip is fixed;
no "crowding out" effect; could even have "crowding in," if there's a marginal
propensity to invest

(2) Government finances its deficits by borrowing (selling bonds
-- national debt), must pay interest on that debt---> obligation that must be met in future-- interest on the national debt = $200 billion per year (in
every year since 1992. Was only $43 billion in 1979, broke $100 billion
in 1984, $150 billion in 1988.)
-- McConnell & Brue's textbook (p. 392, "Shifting Burdens" section)
takes issue with this, calling it a popular misconception, because "we
owe it to ourselves." They say that higher taxes and spending cuts to pay
for interest on the debt are exactly offset by interest payments to American
bondholders. They miss two key point, though: (1) Much of the debt is held
by foreigners -- 23%, according to their own chart, on p. 391. (2) The
(rich) Americans who receive T-bond interest are not exactly the same people
who pay the taxes or whose spending programs are cut to pay for that interest.
-- Keynes, Mr. Fiscal Policy himself, thought budget should be balanced
"over the business cycle"-- run deficits during depressions, surpluses
during booms

(3) Large deficits may be inflationary -- they stimulate aggregate
demand (AD curve shifts out, causing demand-pull inflation); also,
the government may try to finance its deficit by printing money to pay
its debts (monetizing the debt; the U.S. doesn't do this,
but many countries do, and it can lead to hyperinflation).

(4) Political: raises questions about the size of government. (Big deficits
allow the government to spend more money. If you're a conservative Republican
and want government spending to be as low as possible, then you might dislike
deficits for that reason.)